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Parsing the Debate Over the Volcker Rule

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Let's translate. The civilized world, finance and regulatory division, is furiously writing comment papers on the now-famous Volcker Rule to get in under the deadline. Why do they wait, like tardy students, until the last minute? (I'm sure there's a reason beyond procrastination that has to do with the higher orders of spin.) Paul Volcker himself, regulatory Olympian and namesake of the rule banning the banks from speculative activities, weighed in with a 2,000-word comment brushing off the critics, including plaintive voices from Europe worried about sovereign debt markets and the usual handwringing from the big U.S. banks concerned about profitability; he then followed up with a condensed version for the Financial Times today. Meanwhile, The New York Times' Andrew Ross Sorkin nervously enters the lists not quite to frontally battle Volcker -- that's J.P. Morgan Chase & Co.'s Jamie Dimon's job -- but to poke him a bit with his lance as he lumbers by. Sorkin differs with the great man on a meme that may have more to do with the hyperbole around the rule than anything Volcker has actually said: that the imposition of a ban on proprietary trading would not produce costs. Sorkin says it will.

Sorting through this is like brushing a hairy dog. In his FT op-ed, Volcker does not say the rule would not produce costs, but rather that the ban on proprietary trading is "seemingly less draconian" than European attempts to impose a financial transaction tax or British moves to ringfence trading and investment banking. In fact, all regulatory change produces some costs; they can't be avoided. There are winners and losers, inevitably; in the short run, win-win is a fairy tale. But there are also costs to the status quo: the risk that some massive trade will blow up, of course, but also the so-called hidden subsidies that too-big-to-fail banks get in the market and (for some) the baleful affect of highly speculative markets. Sorkin is viewing the cost issue extremely narrowly, even parochially; he is looking at costs of a change in policy to a handful of large, mostly New York, institutions, like J.P. Morgan or Goldman, Sachs & Co. And from that narrow perspective, he's exactly right: Some business will be lost to those banks (and gained by others), some liquidity may be lost, and certain kinds of complex trades or transactions may either cost more to get done or may not get done at all. Some traders at those banks will lose their jobs or see their compensation reduced. These costs may be passed along to customers, from hedge funds to corporates, which may find it a little more expensive (in some cases impossible) to engage in complex finance.

Sorkin, who seems to view the quantity of the anti-Volcker Rule comments as a sign of their validity, also brings up that tired old notion that the big global U.S. banks will find themselves at a disadvantage to European institutions. That's a tricky argument right now, and not just because it's wheeled forth every time a regulator looks crosswise at Wall Street. For one thing, the European banks may well be staring at years of austerity, recession, cleanup, restructuring -- not to say their own restrictive rulemaking, which may only get worse as the bailouts mount. For another, the "competition" here is viewed as a bank-to-bank zero-sum game, without looking at complicating factors such as customer or real-economy benefit or cost. Lastly, how can the European banks complain about how much damage the Volcker Rule will do to them, and still be capable of dominating their American brethren?

Volcker, on the other hand, may well view those additional costs and that potential illiquidity as a beneficial outcome -- not as a cost but as a gain. Volcker is notoriously not a fan of speculation, particularly at banks with either deposit guarantees or too-big-to-fail status. He famously does not believe that financial innovation beyond ATM machines -- derivatives, structured finance, efficient markets and rational expectations -- has produced much, if any, good. Therefore, he is not a believer that more liquidity is always better, that cheaper trading is more "efficient" and safer. It's not difficult to imagine him nodding approvingly if the Volcker Rule reduced risk at the big banks (he doesn't deal with how the banks might struggle within the rule's constraints by shifting risk elsewhere) and if entire classes of complex financial transactions, which can only be executed in highly liquid markets, simply went away. And as he argues in the FT, "Is there really a case that proprietary trading is of benefit to the stability of commercial banks, to their risk profile, and to their compensation practices and desirably fiduciary culture?" Obviously, he's not awaiting your answer. Note, however, where his emphasis falls: on stability. For Volcker, what matters with the banks is their stability. For Dimon, and for Sorkin, what matters is profitability. For sovereigns, it's highly liquid markets to sell their debt.

Who's right? Who's wrong? Who knows? The bank chiefs like Dimon are talking their own book, and they have the embarrassing reality of the financial crisis to cope with; and as for sovereigns, well their record isn't much better. Since big bankers view their institutions as the most important part of the U.S. financial system, then anything that burdens them with "costs" must be bad for everyone else -- if only because, according to the banks, it always gets passed along (which may or may not occur, depending on competition). At the very least, that latter belief is untested. Volcker, on the other hand, carries enormous authority and prestige; as a retired skeptic and central bank god, he can claim he was never captured. But no one's right all the time, and he's positing a future that's by definition uncertain. Volcker's deepest experience was in a very different economy than the finance-driven, interconnected, innovation- and complexity-rich one we have today. He is, in a sense, trying to turn the clock back, which always contains a degree of risk. It's like going home again. Maybe it's not all that you remember; maybe you've changed; maybe they've changed. But it's different.

It's possible, as Volcker suggests in the FT, that this entire kerfuffle over the Volcker Rule is just hot air and that under it the big banks can do most of what they're doing today and the world can spin on a little more safely. But we won't really know the full costs, not to say the unintended consequences, before we try it out and drive it awhile. By then, we'll have changed even further, making a U-turn unlikely. And by then, given the sheer complexity of global finance, it may well be impossible to parse out the costs or the benefits and declare a winner.

Robert Teitelman is editor in chief of The Deal magazine.